The chancellor has said she wants to avoid a “return to austerity”. He has also said that he will present a budget that favors investment and growth. These are laudable goals, but he must fix a disastrous set of public finances, a difficult task not helped by the £22bn overspending uncovered this summer. This is the trilemma facing Rachel Reeves ahead of the government's key first budget. Here's how you could try to approach it.
Challenge 1
End austerity
With local government cut, prisons at capacity and a backlog of court cases, avoiding austerity is easier said than done. Jeremy Hunt's inherited plans were to further cut some public services during this parliament. There are plans to increase spending on schools, defense and the NHS, but other departments are suffering, including the Home Office. Avoiding further cuts will require £20bn of additional spending, and more if Reeves is to undo the legacy of previous bouts of austerity.
Challenge 2
Financing of public services
The chancellor has made clear that she plans to balance daily public spending with tax revenues, probably by the end of parliament. Any additional money for public services will therefore require tax increases, on top of the £24 billion already announced by Hunt.
Since Reeves has promised not to touch VAT, income tax and national insurance, which account for three-quarters of all tax revenue, his room for maneuver is limited.
But there are other tax options available. The capital gains tax is ripe for reform as rates are unjustifiably lower than other forms of income. For example, the top tax rate on earned income is 53%, but some capital gains face a top rate of only 20%.
Reeves should also make CGT harder to avoid by closing loopholes, including those that allow the rich to leave the country without paying tax. Overall, this package of changes could raise around £12 billion. Some will complain that capital will simply leave the country (hence the exit charge), but equalizing the tax regime will generate revenue and leave a better system.
The inheritance tax is widely hated, even though less than one in 20 estates pay it. This is partly because the super-rich can often avoid it altogether. Clamping down on loopholes would be fair and could raise around £2 billion.
Pension taxes are another area for reform, but the chancellor must be careful not to discourage people from saving. This is likely to rule out cutting pension tax relief, but an alternative would be to apply NI to employers' pension contributions. Doing so would raise £8bn even after combining this with a move to exclude NI workers' contributions so their savings go further. Critics will argue that this will disincentivize employers from investing more in workers' pension funds. But it is still the simplest and least harmful way to raise additional income from pensions.
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Challenge 3
Investing in Britain's future
The chancellor wants to place growth at the center of her budget. Expect plenty of policy announcements, backed by increased public investment and infrastructure spending. But once again he has inherited Hunt's plans to reduce public investment. If it instead tried to keep this at 2.4% of GDP, that would mean around £30bn a year of extra spending by the end of parliament.
Providing the necessary additional investment in our public services and infrastructure – from energy grid modernization to housing construction and better transport links – within current fiscal rules would require significant tax increases or spending cuts elsewhere. That's not realistic, so the chancellor has indicated she will change the existing rule that debt must fall as a percentage of GDP at the end of the forecast period.
Better would be a new “public sector net worth” standard that recognizes Britain's public assets and liabilities. This, accompanied by scrutiny of infrastructure spending to ensure value for money and well-planned projects, would reassure markets that public spending is under management. It would also help deliver much-needed investment to Britain.